Everything you need to know about the ‘fiscal cliff’

The “fiscal cliff ” is an inept metaphor for the looming consequences of some very bad congressional decisions.

On or around Jan. 1, about $500 billion in tax increases and $200 billion in spending cuts are scheduled to take effect. That’s equal to about 4 percent of GDP, which is, according to the Congressional Budget Office, more than enough to throw us into a recession (more on that later).

Analysts disagree on exactly how quickly the recession would begin. That’s why the “cliff ” metaphor is inept. If financial markets freak out, it might happen very quickly, proving the “cliff ” imagery correct. But it might happen gradually, affirming those who’ve argued it’s a “slope.”

Either way, both parties agree it shouldn’t be permitted to happen at all. But that’s the rub. The reason that the fiscal cliff could push us into another recession in 2013 is because it enacts too much deficit reduction upfront, not too little. And yet, deficit reduction is something that most members of Congress support, at least in the abstract. So both sides want to replace the fiscal cliffwith something. The question is,with what?

What is the fiscal cliff in one sentence?

Much too much austerity, much too quickly.

If it’s not a cliff, what is it?

The term “fiscal cliff ” comes from testimony Federal Reserve Chairman Ben Bernanke delivered before Congress earlier this year. But, as we mentioned, the “cliff ” imagery has sparked some dissent. The Center on Budget and Policy Priorities thinks it’s more of a “slope.” The Economic Policy Institute calls it an “obstacle course.”

We call it the “austerity crisis.” That solves two problems. First, the danger the economy faces is too much austerity too quickly, so swapping the term “fiscal” for the word “austerity” actually better reflects the situation. Second, while we don’t know if it’ll be a cliff or a slope, we do know that it will, if permitted to go on for long enough, be a crisis. Thus, the “austerity crisis.”

What’s in it?

Taxes

Five tax measures have provisions expiring at year’s end:

2001/2003 George W. Bush tax cuts. These cut individual income tax rates, pared back the estate tax, lowered rates for investment income (such as capital gains and dividends) and expanded a number of tax credits, including the child tax credit. According to the Economic Policy Institute, these would cost $203 billion next year if extended.

2009 stimulus. This included expansions of the earnedincome tax credit, which provides aid to low-income workers, as well as the child credit and the American Opportunity tax credit, which helps families pay for college tuition. Extending these would cost $10 billion next year.

Payroll tax holiday. This was included in the December 2010 tax deal and slashed the payroll tax rate on employees from 6.2 percent to 4.2 percent. Extending it would cost $115 billion next year.

Alternative minimum tax. Intended as a baseline tax for high earners, the AMT is not indexed for inflation and will hit a lot of middle-class taxpayers if not “patched” before next year. A patch would cost $114 billion.

Extenders. This is the catch-all term tax wonks use for corporate tax breaks that need to be extended regularly. Doing that again, as per usual, would cost $109 billion.

Spending cuts

Four types of spending cuts take effect next year:

The sequester (or, as we sometimes like to call them, the big,dumb spending cuts that no one wants). Mandated by the Budget Control Act of 2011 (better known as the debt-ceiling compromise), this institutes a 2 percent cut in physician and other providers’ Medicare payments, and an across-the-board cut of 7.6 to 9.6 percent in all discretionary spending, except on programs for low-income Americans. The cuts are evenly divided between defense and non-defense programs, with analysts predicting a crippling effect on all affected departments and agencies. The sequester can be averted by repealing the portion of the Budget Control Act mandating the cuts, which amount to about $110 billion next year.

Budget caps. Also in the Budget Control Act, these set a firm limit on discretionary spending within which policymakers must operate. They are set to reduce spending by $78 billion next year.

Doc fix. This policy, passed by every Congress for 15 years but now lapsing at the end of 2012, temporarily reverses cuts that Congress passed, and President Bill Clinton signed, as a deficit reduction measure in 1997. The cuts, known as the sustainable growth rate, or SGR, require that growth in medical provider payments not exceed growth in gross domestic product. If the doc fix is not extended, physician payments would fall by almost 30 percent, dwarfing the cuts enacted as part of the debt-ceiling deal. That would cut spending by $14 billion next year.

Unemployment insurance. Unemployment insurance was expanded following the recession, and because of the slow recovery this expansion has been regularly extended. Doing so again would cost $39 billion.

Debt ceiling

When exactly the debt ceiling is next reached depends on how much the government actually spends and taxes in the coming months. But most analysts think the next debt-ceiling increase will come due around February. The Bipartisan Policy Center estimates we’ll have to raise the debt limit by anywhere between $730 billion and $1.25 trillion to avoid the debt ceiling for all of 2013 (depending on whether the Dec. 31 fiscal measures are enacted or not) and between $1.3 trillion and $2.2 trillion in 2014.

A fiscal-cliff deal is likely to include an increase to the debt limit. But in a world without a deal, an ongoing austerity crisis could be worsened by a default.

The economic consequences of that are hard to even imagine, but we’re talking about a crisis on the order of what we saw in 2008, at least.

What happens if we go over?

Recession

Analysts expect that the austerity crisis will weaken the economic recovery and quite possibly plunge the United States back into a recession. The Congressional Budget Office predicts that the U.S. economy will shrink by 0.5 percent in 201, and unemployment will spike up to 9.1 percent from its current level of 7.9 percent, if no fix is passed. However, if all policies, including the payroll tax cut, are extended, the economy will grow 2.4 percent.

Deficit reduction

If the austerity crisis hits in full, both short- and medium-term deficit problems in the United States would vanish. The CBO projects that under current law, debt held by the public would fall to only 58 percent of GDP by 2022, below the 60 percent mark that many economists warn against exceeding. By contrast, debt would climb to 90 percent of GDP if current policies continue, the highest point since after World War II.

Tax increases

The Tax Policy Center estimates that if we go over the fiscal cliff, average Americans will see their tax bill rise by $3,446 in 2013. That average obscures a bigger hit to the rich than the poor: Taxpayers making more than $1 million will, on average, see a $254,000 tax hike, equal to about 11 percent of their income, while taxpayers making between $40,000 and $50,000 will see a $1,700 tax hike, equal to about 4.4 percent of their income.

Where do the parties stand? What do they agree on?

Both parties agree that doing nothing and letting all the scheduled tax hikes and spending cuts take effect for all of 2013 would be a terrible thing for the economy.

However, while they oppose the fiscal cliff’s particular form and pace of deficit reduction, the leaders of both parties still want to enact major deficit reduction that brings down the long-term deficit. Both sides agree that such a deficit plan should include both tax revenues and entitlement cuts, generally speaking.

What do they disagree on?

They don’t agree on taxes: Democrats want to hike taxes on the wealthy by about $1.6 trillion, and they want about $1 trillion of that to come from letting the top marginal tax rate snap back to its Clinton-era level of 39.6 percent. Republicans oppose tax increases in general and increases in marginal tax rates in particular.

The two parties also disagree about how and where to cut spending: Republicans want to make more dramatic changes to Medicare, Medicaid and other entitlement programs, as well as bigger cuts to domestic discretionary spending.

How can we solve it?

Just go over

The simplest option for Congress and the White House would be to do nothing. Taxes would go up. The military and domestic spending cuts in the sequester would bite down. This would be the single largest act of debt reduction in American history, cutting some $1.2 trillion from the deficit over the next two years. Trouble is, that much austerity would probably also induce a recession. Moreover, Congress would still need to vote to lift the $16.4 trillion debt

ceiling by February or so. Otherwise, the U.S. government would no longer be able borrow money to fund its obligations.

Just go over and then make a deal

Another possibility is that lawmakers don’t reach a deal by Dec. 31. The United States goes over the fiscal cliff. But it’s only temporary. After all, those tax hikes and spending cuts don’t kick in with full force immediately. So there’s still time to make a deal when the new Congress convenes in January.

Why would lawmakers do this?

It might make a deal easier. Right now, the two parties are having a tough time reaching an agreement, because Democrats want higher taxes on the wealthy and Republicans mostly refuse to vote for any tax increases at all. But if we go over the cliff, taxes automatically go much, much higher than either party wants. Now the two parties simply need to debate how to cut taxes from this new baseline.

The downside is that Congress and the White House might not have much time to negotiate a deal in January or February before financial markets start nose-diving.

Extension

There’s nothing stopping Congress and the White House from postponing the fiscal cliff until 2013 or 2014. Congress would simply vote to extend all (or some) of the Bush tax cuts and payroll tax cuts. Then Congress votes to override the sequester, so that none of the military and domestic spending cuts kick in.

The upside here is that there’s no recession. The economy gets time to mend. The flip side is that the deficit would continue to grow. The CBO estimates U.S. debt would be $1.2 trillion higher over the next two years if Congress extends everything, compared with if we went over the cliff.

Small deal

Congress doesn’t need to make a big sweeping deal on the debt right now. It could do something smaller. One possibility being talked about is that Republicans would let the Bush tax cuts for income over $250,000 expire, as President Barack Obama wants. That would raise about $80 billion in 2013. In return, Democrats would find $80 billion in spending cuts. Then Congress extends (most) of the rest of the tax cuts. That’s a small bit of austerity next year but nothing like the full cliff.

Grand bargain

At the moment, there’s a lot of talk in Washington about a “grand bargain” between Republicans and Democrats. This would involve avoiding sharp austerity in 2013. It would also involve some mix of spending cuts and tax increases that are gradually phased in over the next decade, so as to slowly bring down the U.S. national debt. It would also include substantial changes to entitlement programs such as Social Security, Medicare and Medicaid.